Most Popular Cryptocurrency Hedging Strategies

One day you're riding high with Bitcoin climbing to new heights; the next, it feels like the entire market is crashing down. That unpredictability is why investors are turning to hedging strategies—an essential tool for managing risk in the wild world of crypto. Hedging allows traders to safeguard their portfolios against massive losses while still maintaining exposure to potential gains.

In this guide, we’ll dive into crypto hedging, why it’s necessary, and the different strategies you can use to protect your investments. Whether you’re new to crypto or already have some skin in the game, understanding these tactics can be a game-changer.

What is Crypto Hedging?

Hedging in crypto, or any asset class, refers to using financial instruments or strategies to reduce the risk of adverse price movements in your portfolio. Essentially, it's a way to "insure" your investments. In a volatile market like cryptocurrency, where prices fluctuate wildly in short time frames, hedging can help you sleep a little better at night.

For instance, if you hold Bitcoin but worry about a market downturn, you can hedge your position by taking a short position or using other financial instruments to reduce your potential losses if Bitcoin’s price falls.

Why Should You Hedge in Crypto?

The primary reason investors hedge in crypto is to manage risk. Volatility is one of the defining features of cryptocurrency, and even though it brings profit opportunities, it also carries significant risks. For example, Bitcoin and Ethereum have experienced swings of more than 20% in a single day multiple times. While these price movements can lead to massive profits, they can also cause painful losses if the market turns against you.

There are several benefits to hedging in crypto:

• Protection against downside risk: if you're holding a long-term position, like Bitcoin, a hedge can protect you during market dips.
• Lock in gains: if you’re already in profit from a rising market, hedging can help ensure you don’t lose those gains if the market turns.
• Stable income in a volatile market: with the right strategy, you can generate consistent returns, even when the market is shaky.

Now that we’ve covered why hedging is necessary, let’s break down some of the most popular crypto hedging strategies you can implement.

Most Commonly-Used Crypto Hedging Strategies

1. Using Stablecoins as a Safe Haven

Stablecoins like USDT (Tether), USDC (USD Coin), and DAI are pegged to the value of fiat currencies like the U.S. dollar. These coins provide a “safe haven” for crypto investors during times of market turbulence. When the market becomes too volatile, investors can convert part or all of their crypto holdings into stablecoins to preserve capital.

How it works:

Let’s say you hold 5 Bitcoins, and Bitcoin is trading at $60,000. If you believe that the market is due for a downturn, you could convert your Bitcoin into USDT. If Bitcoin’s price drops to $50,000, you could then re-buy Bitcoin at a lower price and effectively protect your portfolio from the loss.

Benefits:

Stablecoins are easy to trade, widely available, and maintain value even during market corrections.

Drawbacks:

You miss out on potential gains if the price moves higher while you’re holding stablecoins.

2. Short Selling Crypto

Short selling is another popular hedging strategy, especially for more advanced traders. When you short sell, you borrow a cryptocurrency and sell it at the current price, hoping to buy it back later at a lower price. If the asset’s price drops, you profit from the difference.

How it works:

Imagine Bitcoin is trading at $40,000, but you believe its price will drop. You borrow 1 Bitcoin and sell it immediately for $40,000. When Bitcoin’s price drops to $30,000, you buy back 1 Bitcoin, return it to the lender, and pocket the $10,000 difference.

Benefits:

With short selling, you can actually take advantage and profit from falling markets.
It’s a powerful hedge for traders who want to protect their portfolios against downside risk.

Drawbacks:

Short selling carries significant risk if the market moves against you, and it requires a margin account, which may not be accessible to all investors.

3. Futures and Options Contracts

Derivatives like futures and options are frequently used for hedging in traditional finance, and they’ve become increasingly popular in the crypto world. Futures contracts obligate you to buy or sell an asset at a predetermined price on a future date, while options give you the right (but not the obligation) to do the same.

How futures work:

Suppose you hold 10 Ethereum, but you’re worried about a price drop. You can enter into a futures contract to sell Ethereum at a certain price (say, $3,000) at a specific date in the future. If the price drops to $2,500, you still sell at $3,000, protecting your position.

How options work:

Options give you flexibility. For instance, you can purchase a put option, which gives you the right to sell an asset at a certain price before a specified date. If Ethereum drops, you can exercise the option and sell at a higher price, protecting yourself from the loss.

Benefits:

• Futures and options offer customizable risk management and can be tailored to specific price points or timeframes.
• Options provide more flexibility compared to futures, as you aren’t obligated to exercise them.

Drawbacks:

• Futures carry the risk of liquidation if the market moves against your position.
• Derivatives can be complex for beginners and require a good understanding of leverage and margin.

4. Crypto ETFs and Index Funds

Another strategy that has been gaining traction is using crypto exchange-traded funds (ETFs) and index funds to diversify and hedge against risk. While these products are more common in traditional markets, crypto ETFs are now available, such as the ProShares Bitcoin Strategy ETF.

ETFs allow you to gain exposure to a basket of cryptocurrencies without holding them directly. If you believe one asset will underperform, holding a broader index reduces the impact of its decline.

How it works:

As you invest in a crypto ETF, you’re diversifying your portfolio across multiple assets or strategies, which can help reduce the impact of volatility in one specific cryptocurrency.

Benefits:

1. You get broad market exposure with one investment.
2. It's a simple, passive way to hedge against individual asset risk.

Drawbacks:

1. Fees may be higher than directly holding crypto.
2. You don’t have direct control over the underlying assets.

5. Perpetual Swaps

Perpetual swaps offer a way to bet on crypto price movements without actually owning the coins.

How it works:

1. Unlike traditional futures contracts, perpetual swaps don’t have an end date, so you can keep your position open as long as you want.
2. The perpetual swaps’ inner workings revolve around a funding rate system. Traders need to pay or receive funding fees depending on the price difference between the swap and the spot market. This is the way to keep the swap price in line with the actual asset price.
3. Perpetual swaps usually let you trade with leverage, meaning you can control a large position with less upfront cash.
4. All trades settle in cash, not in actual crypto, keeping things simpler and reducing the risk of managing the actual coins.

Benefits:

• You can protect yourself against unwanted price moves in your crypto portfolio. For instance, if you're worried that Bitcoin might drop in value, you can short a Bitcoin perpetual swap to cushion potential losses.
• No expiry date means more flexibility for your strategy. You can adjust your hedging positions anytime as the market shifts without being tied to a contract end date.
• Perpetual swaps are typically more liquid than the actual crypto assets, so it’s easier to jump in and out of trades quickly.

Drawbacks:
The whole idea of trading with leverage can increase your chances of getting liquidated if things go south.

The Steps to Follow Before Choosing and Applying a Hedging Strategy

Figure out your main position

1. Take stock of your assets – make a list of the cryptocurrencies you already own or are thinking about buying.
2. Check your exposure –  get a sense of how much of your portfolio is at risk from market ups and downs.

Spot the risks

1. Market swings –  be aware that the crypto market can be super volatile, with big price jumps and drops.
2. Unique risks – look out for risks specific to your coins, like changes in regulations or tech issues that could impact their value.

The Bottom Line

Hedging isn’t about eliminating risk entirely—it's about managing it. With the right strategy, you can protect yourself from major market swings while still enjoying the upside of crypto investments. Whether you prefer using stablecoins, shorting, or diving into complex derivatives, there’s a hedging tactic suited for every type of investor.

In all, the ability to protect your portfolio during downturns is as valuable as riding the bull markets.